News In Charts: A Thoroughly British Form of Forward Guidance

This research note is provided by Fathom Consulting. All of the charts below and many many more, covering a range of topics and countries on both the macroeconomy and financial markets are available in the Chartbook to Datastream users at www.datastream.com. Alternatively you can access Fathom’s Chartbook at www.fathom-consulting.com/TR.

This week’s UK Inflation Report press conference was the most closely watched in years, if not decades. In addition to updating us on the outlook for GDP growth and inflation, the Bank of England’s Monetary Policy Committee was invited to set out its views on the use of explicit forward guidance as a policy tool, and on the relevance of intermediate targets and thresholds. To be fair, this is something that individual members have always debated behind the scenes. The MPC has merely been asked to show its workings.

Explicit forward guidance … designed by a committee

We learnt this week that the MPC had, at its August meeting, voted to pursue a policy of explicit forward guidance conditional on the unemployment rate. This came as no surprise – out of all the available options it is the approach that is the most logical and easiest to understand. It also has the advantage that the US Federal Reserve is already doing it. Specifically, the MPC has said that it intends neither to raise Bank Rate, nor to reduce the stock of asset purchases, until the headline (Labour Force Survey) unemployment rate has fallen from its current level of 7.8% to 7.0% or below. But unfortunately it does not end there.

What took us by surprise was the specification of three ‘knockouts’, or get-out clauses: two related to price stability; and one related to financial stability. Explicit forward guidance will apply only if the following three conditions are met:

1. It is more likely than not that CPI inflation will be below 2.5% 18 to 24 months ahead
2. Medium-term inflation expectations remain sufficiently well anchored
3. In the judgment of the Financial Policy Committee, the stance of monetary policy does not pose a significant threat to financial stability that cannot otherwise be contained by the tools available to it and to other relevant authorities.

The purpose of the first get-out clause is straightforward. In broad terms, it is an acknowledgment of the fact that the NAIRU – the rate of unemployment consistent with stable inflation – varies over time. It gives the Committee an escape route. Effectively, it says that policy will remain at least as loose as it is today so long as unemployment remains above 7%, and so long as this does not pose unacceptable risks to price stability. It is interesting because it effectively gives a gauge of the extent to which the Committee is willing to ‘look through’ deviations of inflation from target.

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Our first chart compares headline CPI inflation with the new 2.5% ‘trigger point’. It shows that, since the onset of recession in early 2008, inflation has been above 2.5% almost all of the time. Were the Committee to have been blessed with perfect foresight, the first price stability knockout would have been triggered right the way through the period of QE I – 18 to 24 months ahead of the period from March to November 2009 inflation averaged 3.6%. In practice, of course, that burst of high inflation took the Committee by surprise. Since the beginning of 2008, the MPC has forecast that inflation was more likely than not to exceed 2.5% in 18 to 24 months’ time on just one occasion – and that was as recently as February of this year.

In view of the extent to which inflation has overshot the 2% target in recent years, the specification of a trigger point at just 2.5% is a bold move. The first price stability knockout has the potential to act as quite a hurdle, but if and only if the Committee is able to improve the accuracy of its forecasts. The second and third knockouts are less precise, and offer a substantial degree of wriggle room.

Our second chart shows two measures of UK inflation expectations. Long-term inflation expectations of the general public, as reported by the Bank of England, have been on an upward trend since QE began in early 2009. According to the latest quarterly survey, results of which were published in June, the median expectation was that in the long-term inflation would be 3.6%. Ten-year forward breakeven rates are close to 3.7%. In the UK, inflation protected gilts are linked to RPI rather than CPI. Nevertheless, even allowing for a typical 0.7 percentage point gap between the CPI and RPI measures, and an inflation risk premium which in normal times is thought to be around 0.5 percentage points, a forward breakeven rate of 3.7% is very much at the top end of what might be seen as consistent with a CPI target of 2.0%. At what point either long-term expectations of the general public, or forward breakeven rates reach a level that is inconsistent with medium-term price stability, we do not know.

Viewed in isolation, each of the knockouts sounds eminently sensible. The difficulty, however, is that they muddy the waters. In the words of Governor Carney, forward guidance at the Bank of Canada worked because ‘… it reached beyond central bank watchers to make a clear, simple statement directly to Canadians’. From the perspective of the Great British public, the statement we heard this week, together with the three get out clauses, ought to be anything but clear. It smacks of forward guidance designed by committee. Which of course is what it is.

Immediate publication of forecast detail improves transparency

Forward guidance aside, this week’s press conference brought one very welcome change of substance. The Inflation Report now includes tables showing various parameters of the forecast distribution for both GDP growth and inflation. Actual numbers! Previously, these had always been held back until two weeks after publication.

Turning to the numbers themselves, it is clear that the Committee has revised up substantially its forecast for UK growth. The MPC’s modal forecast for growth in 2013 is now 1.5%, and in 2014 2.7%. That compares with figures of 1.2% and 1.9% at the time of the May Report. The MPC’s forecasts for growth are higher than our own, which are 1.2% and 2.0% respectively. Importantly, although the MPC expects faster growth than us, it expects much lower inflation. The Committee’s modal projection for inflation at the end of 2014 is 2.4%. Our own is 3.6%. Implicitly, the MPC’s view of the amount of spare capacity in the UK economy is very different from ours. That has probably been the case since 2008, and offers one explanation for the MPC’s disappointing forecast record over that time. This is not just point scoring, but critical to the success of the new framework. Increased transparency is important, but so too is accuracy. The key difference between our forecasts is the evolution of supply. The MPC, collectively, believes it will rise to match demand. As we explained last week, Fathom is less certain.

The performance of UK productivity since early 2008 has been dire. It is normal to see a drop in productivity during the early stages of a downturn as output adjusts more rapidly than employment. But it usually bounces back within a year or two. US productivity is already 8% higher than it was when the recession hit. In the UK it is 5% lower, and it has gone sideways for the past four years.

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The MPC is seemingly of the view that an increase in demand will by itself call forth greater supply. As GDP rises, so too will productivity. This might be the case if the bulk of the decline in UK labour productivity was a consequence of labour hoarding. So workers are still as productive as ever, it is just that they have nothing to do because demand is so weak. We disagree fundamentally with this view. The fall in UK productivity is something fundamental. As we set out in last week’s Alpha Now, ‘UK pursues Growth at any cost’, our research suggests that this UK recession, in contrast to those of the early 80s and the early 90s, has been characterised by a series of large negative shocks to supply. With the amount of slack in the UK economy far less than the MPC imagines, it is our view that a sustained period of stronger economic growth will lead to higher inflation.

If we are right, if the increase in demand does not call forth greater supply, then the unemployment rate will fall much faster than the MPC has assumed in its central projection, which does not hit 7.0% until 2016 Q3. If the Committee is true to its word on forward guidance, the Bank of England may need to raise interest rates far sooner than that.

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